Download - ACCT 2200 - Chapter 11 P2
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Chapter 11
Capital BudgetingACCT 2200
PROFESSOR THOMAS BOURVEAU
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Capital Budgeting Methods
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Predict the internal rate of returnand describe its relationship to net
present value.
Learning Objective 11-4
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Internal Rate of Return (IRR)
Present
value of
cash inflows
Present
value of
cash outflows=
The net present value equal zero.
The internal rate of return is the interest
rate that makes . . .
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5
Using the cash flows for the preceding example, we get:
Internal Rate of Return ( IRR)
The internal rate of return is the discount rate which equates the NPV of a
stream of cash flows to zero.
t
t
IRR
CF
)1(0
If the IRR can be determined, then, in general,
choosing IRR > r often leads to the same decision as choosing NPV > 0.
The IRR criterion is useful for choosing among projects with the same NPV .
0 = – 90 +55
+60.50
(1 + IRR)1 (1 + IRR)2
IRR = 18% > 10% Accept the project
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Computing IRR in Excel
One important note about the IRR function is that you must
include the original cash outflow in the calculation.
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Internal Rate of Return (IRR)
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ApplicationA local company, Lester Inc. has a minimum required rate of return / cost of capital of 8% per year. The company is consideringinvesting in a robotic project that costs HKD68,337 and is expectedto generate cash flows of approximately HKD 27,000 per year for
the next three years. The approximate internal rate of return of this project is:
A. 8%
B. 9%
C. 10%D. Less than the required 8%
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Profitability Index
The profitability index is the ratio of a project’s benefits (measuredby the present value of the future cash flows) to its costs (or
required investment).
Profitability Index > 1 = Project Acceptable
Profitability Index < 1 = Project Unacceptable
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Comparing Capital Budgeting Methods
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Use the net present value method toanalyze mutually exclusive capital
investments.
Learning Objective 11-5
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Case 1: Lease or Buy Equipment
iKids Touch is trying to decide whether to buy a new copier orlease it from a copier company, and has gathered the following
information about the two options:
iKids Touch uses net present value to evaluate
investment options. If the discount rate is 10%,
should the company lease or buy?
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Case 1: Lease or Buy Equipment
Lease option costs $1,419 less.
To analyze this decision, we can use the NPV method to
compare the relevant costs (in present dollar values) of
each option.
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Case 2: Investing in Automation
iKids Touch is thinking of spending $10,000,000 to
automate a production facility. The investment is
expected to have the following effects:
• Automation will increase the capacity of the plant and allow it
to boost production and sales by 20 percent.•The company will be able to reduce packaging labor cost per
unit by 30 percent.
•Factory supervision costs will increase by $500,000 per year.
•The estimated useful life of the equipment is six years, at which
point it will have a residual value of $1,000,000. Straight-line
depreciation of the assets will be $1,500,000 per year[($10,000,000 – 1,000,000) ÷ 6 years = $1,500,000].
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Case 2: Investing in Automation
iKids Touch uses net present value to evaluate
investments. If the discount rate is 12%, should
the company make the $10,000,000 investment?
This table summarizes the effects on net income. The per-unit costs
in the first column are assumed. Note that automation increases net
income by $1,100,000.
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Case 2: Investing in Automation
Remember that the net present value method is based on cash flow
rather than net income. So, we need to add back the depreciation (a
noncash expense) to net income to get net cash flow. We also need
to incorporate the initial investment (at time zero) and the salvage
value of the machinery at the end of six years.
The positive net present value of $1,196,240 means that the
proposed investment in automation will generate a return in excess
of the 12% cost of capital.
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Exercise E11-7 Your friend Harrold is trying to decide whether to buy or lease hisnext vehicle. He has gathered information about each option but isnot sure how to compare the alternatives. Purchasing a new vehicle cost $26,500, and Harrold expects to spend about $500 per
year in maintenance costs. He would keep the vehicle for five years and estimate the salvage value to be $10,500. Alternatively,he could lease the same vehicle for five years at a cost of $3,480per year, including maintenance. Assume a discount rate of 10percent.
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Use the profitability index toprioritize independent capital
investment projects.
Learning Objective 11-6
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Profitability
Index
Present Value of
Future Cash flowsInitial
Investment÷=
The profitability index is used to prioritize
capital investment projects.
When using the profitability index to prioritize projects,
the preference rule is: the higher the profitability index,
the more desirable the project.
Prioritizing Independent
Projects
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Prioritizing Independent
Projects
iKids Touch is trying to decide how to prioritize their limited
research and development budget. They are
considering these three independent projects.
How should iKids Touch prioritize these three projects?
A, then B, then C
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ApplicationLester Inc. just raised HKD1,000,000 from investors in Hong Kong tofund the creation of a new robot with a cost of capital of 10%. The CEOof the company hesitates between two different mutually exclusiveprojects. Both of them requires an initial cash outflow of HKD1,000,000but have the following cash flow patterns:
Which one should the firm opt for?
Year 1 Year 2 Year 3 Year 4 Year 5 Total
Project A 800,000 600,000 400,000 200,000 100,000 2,100,000
Project B 100,000 200,000 400,000 600,000 800,000 2,100,000
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ApplicationSai Kung Transportation is considering the purchaseof a new junk carrier for HKD8 million. The forecastrevenues are HKD5 million a year and total operatingcosts are HKD4 million. A major refit costing HKD2million will be required after both the fifth and tenth
years. After 15 years, the ship is expected to be sold forscrap at HKD1.5 million.
equired If the discount rate is 8 percent, what is the
NPV of investing in the new ship?